1.1 The importance of counterparty risk in the light of the financial crisis. Many crises in the financial sector during the last two centuries preceded the recent global financial crisis that started in 2007. They can broadly be classified into bank runs, affecting one or more banks (i.e Herstatt-Bank in 1973), bubbles in asset prices and their consequential crashes (i.e. I.T. bubble in 2001/02) and international financial crises, originating i.e. from a currency crisis affecting other financial systems due to financial contagion (i.e. Asian Financial Crisis in 1997).

The actual financial crisis was unusually severe as it caused many banks worldwide finding themselves in financial distress. Due to the low interest level and the lenient borrowing procedures in the U.S. the mortgage market was inflated. The strong devaluation of both the sub-prime mortgage loans in the U.S. and consequently the securitized instruments of the respective loans, resulted in enormous write downs of the banks involved. These turbulences splitted trust amongst the market participants, leading to a drying-up of liquidity. The insolvency of Lehman Brother in 2008 was the first downfall of an international bank caused by large exposure in the American housing market and marked the beginning of a chain reaction pushing some banks into bankruptcy.

This global financial crisis, the most serious after the Great Depression, occasioned a loss for the affected economies by forcing the respective governments to undertake bail-outs by providing capital in order to maintain the pivotal financial system. Estimations from August 2009 amount the worldwide costs to a total of $10,4 bn. excluding the effects of the economical downturn caused by the financial crisis (Commerzbank).

A major reorientation of the regulatory and supervisory system is needed to prevent another financial crisis in the future. It will be crucial to analyze how this recent crisis occurred and to learn from the lessons.

Main factors of the recent crisis and their implications have already been identified and can be summarized as following:

Well-defined criteria for a bail-out of a financial institution, in order to reduce misconduct due to “moral hazard” incentives (“too big to fail”)

Revision of the compensation system, which encourages high-risk behavior in search of short-term profits

Reformation of the regulatory framework, mainly the Basel II framework of the Bank for International Settlements (capital adequacy), and improvement of the transparency in financial markets

Stricter regulations for rating agencies, in order to improve their objectivity and reduce their dependence on their own clients

Improvement of internal risk management

The last factor, the internal measurement of risk factors, is fundamental to the bank’s health and the financial industry will attach importance to improvements.

The world’s 100 largest “Financial institutions are seeking to improve governance and risk management learning the lessons of the recent crisis” and “will double their expenses to the amount of above $100bn in 2012” (Deloitte, 2010), according to a recent survey of chief risk officers or equivalent at 28 financial institutions conducted in October 2009. The “surveyed risk officers estimated that about $20bn of the past and projected increase was a direct consequence of the financial crisis”. Further on they specified that “funds for control functions were going to projects including hiring people in risk management departments, developing ways to model risk and link it to business decisions, and replacing computer systems” (Deloitte, 2010).

Academic research was as well undertaken and unveils that though “sophisticated modeling approaches have been employed within the risk management process, data problems exist in terms of timeliness, relevance and consistency” (Theobald, M.). The reasons for this problem “. is using long past series of data to generate risk inputs in such a changing and volatile market will clearly be inappropriate and lead to suboptimal decision making. Furthermore, the dangers of relying upon single measures have been fully recognized” (Theobald, M.).

Risk management gains in importance and financial institutions try with great effort to optimize if not to revolutionize it. For instance, several institutions attract notice to ‘enterprise risk management’, a pioneering approach which overcomes the classical separation into credit, market and operational risk and offers a firm wide perspective on risk.

BEZUG AUF COUNTERPARTY RISK….

However, in the light of the financial crisis various deficits have been encountered in the management of counterparty risk of OTC Derivatives. The prime example is the American International Group which took on $446 bn in notional credit exposure in selling credit default swaps, which revealed an unprecedented concentration of counterparty risk on one market participant.

1.2 The request for an increased transparency of derivatives

As a direct reaction of the financial turmoil and the downfall of several financial institutions and the subsequent governmental financial aids, the G20 summit met on November 14, 2008. On this day the leader of the G-20 countries expressed their will to implement central clearinghouses for OTC derivatives in order to precautionary reduce losses in case of a failure of counterparties. Further on they “agreed on Nov. 14 on rules allowing the first clearinghouse for the $33 trillion credit-default swap market to open by year-end.” (Bloomberg News, Nov. 17, 2008). This reaction on the governmental part indicates on the one hand how fast a clearing house mechanism can be implemented and on the other hand that governments place great importance on its calming effect to markets.

On both sides of the Atlantic Ocean, the above mentioned intentions were put into national legislation. In February 2009 for instance the Agriculture Committee of the US House of Representatives (2009) approved the legislation in order to “increase the transparency and strengthen oversight of futures, options and OTC markets”. This initiative ended in several legislation proposals during 2009 (e.g. “Over-the-Counter Derivatives Markets Act of 2009”, “Derivative Markets Transparency and Accountability Act of 2009,” etc.).

In Europe the European Commission embarks on the same strategy as the US, expressing their intention to enlarge the use of CCPs to (Bloomberg, July 1 2009) “ensure that it becomes the norm for OTC derivatives markets as a whole wherever possible”.

1.3 Relevance and reasoning for the approach

The author’s approach is to gain inside knowledge of the actual methods used to measure counterparty risk of various over-the-counter products. Though the standard methods are described by academic books it is the author’s intention to analyze the procedures related to real life. Moreover the recent financial crisis revealed the importance for new transparence rules within over-the-counter derivatives markets, which imposes the obligation on banks to more and more disclose their exposures undertaken. This report will unveil how banks are challenging these new requirements. Therefore the author chooses to conduct face-to-face interview with employees who have managerial positions.

Definition of the risk factor and its mitigation

2.1 Definition of Credit Risk

For Resti and Seroni (2009) Credit Risk is the “possibility that an unexpected change in a counterpartys creditworthiness may generate a corresponding unexpected change in the market value of the associated credit exposure”. A more practical definition is given by an exemplary definition from Barclays plc (Annual Report 2009) Credit risk is the risk of suffering financial loss, should any of the Group’s customers, clients or market counterparties fail to fulfill their contractual obligations to the Group. The two definitions both from the academic and from the practitioner’s look-out are similar.

Continuative, credit risk comprises three different areas:

“Default risk and mitigation risk”: The former represents the risk resulting of a complete nonperformance due to the insolvency (apart from the liquidation of collateral, etc.) whereas the latter describes the risk of down-grading of the credit rating

“Risk as an unexpected event”: The probability of a surprisingly worsening of the counterparty’s creditworthiness, which wasn’t taken into account at a former date

“Credit Exposure”: Summation of all exposure undergone with on- and off-the-balance sheet transactions (including OTC Derivatives).

Exposure frequently doesn’t t have any equivalent on the market, because

For FIs it is difficult to compute the exact exposure,

2.2 Definition of Counterparty Risk

According to Resti and Sanoni “Counterparty risk is the risk that one counterparty of a financial contract will default either prior to the expiration of the contract (pre-settlement risk) or at the time of the settlement of the contract (settlement risk) and will not make all the payments required by the contract”. Exchange traded derivatives, which are not traded over-the-counter, are not affected by counterparty risk thanks to the intermediating clearing house which vouches for the payments on which the counterparties agreed on.

In general, counterparty risk refers only to Over-the-Counter derivatives, which are privately negotiated agreements between two counterparties.

2.3. Counterparty Risk Mitigation

Even if a financial institution holds (or commissioned another party to do so) collateral against counterparty exposures, it may not be able to realize it or liquidate it at prices sufficient to cover the full exposures. Due to the fact that many of the hedging strategies utilized by the banks also involve transactions with financial services counterparties, a failure of several counterparties (contagion effect throughout the economy) to settle endangers the group’s effectiveness for hedging and other risk management strategies. SINNVOLL.

In the next chapter the functioning and meaning of clearing houses and bilateral agreements with a view to counterparty risk mitigation for OTC contracts will be analyzed. As an introduction to this next chapter the development of the most important OTC markets will be analyzed.

Clearing Houses

3.1 Size of the OTC Derivative Market in G10 countries and Switzerland

In order to fully understand the increasing importance of clearing houses with respect to OTC derivatives, it is worth to analyze the movement in the OTC markets during the recent financial crisis.

The BIS makes use of three concepts for measuring the OTC derivatives market. The notional amount outstanding is defined as the gross sum of all OTC derivative deals made and not settled yet as of the reporting date. According to this definition the notional amount outstanding illustrates an indication of the size of the market. The “semiannual OTC derivatives statistics at end-June 2009” (BIS 2009), reports that the notional amount outstanding of all OTC derivatives in the G10 countries and Switzerland accounts for $ 604,622 bn. as of 30 June 2009.

Whereas the risk in derivatives is rather approximated with the help of the gross market value, which approximates the “open contracts that are either in a current gain (or loss) position at current market prices and thus, if settled immediately, would represent claims (or liabilities) on counterparties…Although gross market values capture the economic significance, these values are not netted.” (IMF 2008). As of 30 June 2009 the Gross Market Value accounts for $25,372 bn.

Hence the latter figure does not take into account the netting between counterparties it disregards the existence of collateral; therefore the BIS calculates a third figure: the gross credit exposure. This figure indicates the (ISFL, 2009) “value of contracts that have a positive market value after taking account of legally enforceable bilateral netting agreements, i.e. it measures netted credit exposures between counterparties”. In December 2008 the latter increased to the level of $5.0 trillion — a level never seen in the past.

Appendix 1 shows in detail the development of the OTC market in the above mentioned countries in terms of notional amount outstanding and gross market value sorted by risk categories. First of all the data shows that interest rate contracts forms the largest part of the OTC derivatives market in total during the period under observation. Further on it can be stated that though total notional amounts decreased from June 2008 to December 2008 by 19.95 %, the gross market value of all OTC contracts increased by 58.23% in the same period of time. The main responsibility for this oppositional development lies within the development of interest rate contracts and credit default swaps markets, which decreased considerably by notional amounts and isochronal increased by gross market value.

According to the ‘International Financial Services London’, a private-sector organization, the “key contributor to this decline (of notional amounts) was the move to central counterparty clearing of some contracts following concern over systemic risks posed by OTC derivatives”

Table 1: Measures of activity in international derivatives market (Source IFSL Research 2009)

and the “voluntary terminations of contracts reduced the total value of credit default swaps (CDS) contracts.” In addition, the report states that the above mentioned increase in gross market volume is “a result of volatility of prices associated with greater risks in many derivatives contracts.”

A BIS report on CCP for OTC derivatives completes the rationales to (BIS, 2009) “market-makers – the major dearlers who facilitate trading in the OTC derivatives markets – have increased the fees they change (by widening bid-ask spreads) and have also scaled back the level of their OTC derivatives positions. Furthermore, bank managers as well as regulators have pushed to increase capital allocated to counterparty and market-related risks, making derivatives trading more costly.”

As well the exchange-traded derivative recorded a revenue collapse of 27% from 2007 to 2008.

Given this interpretation, it can be summarized that the market turmoil caused a rapidly increasing incertitude amongst market participants leading to sudden margin calls or even total liquidation of OTC contracts due to cancellation. The IFSL (2009) reports that the “Moves to greater centralized clearing have contributed to a 13% fall in the notional value of OTC derivatives from $684 trillion in June to $592 trillion in December 2008”. The subsequent drying up of liquidity of some financial institutions became a major problem ending partly in default of several institutions. Taken into account the above mentioned implications for the transparency of OTC derivatives following the financial crisis, regulators are aiming now to promote the implementation of clearing houses for various kinds of OTC Derivatives.

For the purpose of this report, the most important result is the “flight to quality” towards central clearing houses during bad times and its implications concerning a more extensive application of clearing houses amongst all asset classes.

3.3 Bilateral agreement and Clearing Houses

3.3.1. The difference between bilateral and central counterparty clearing for OTC Derivatives

There are basically three ways of clearing and settling OTC derivates, depending on the market form, please see Appendix 7.4. for a detailed overview):

Bilateral clearing: Completely decentralized structure, involving only the counterparties among themselves

Central Counterparty clearing: Involving the CCP as an intermediary/contractor of each counterparty, after a bilateral agreement is reached

Exchange-based: Using as well CCP, but for absolute standardized products, e.g. Futures

For the report’s sake, we will concentrate on the first two in the further course.

3.2.2. The difference between securities and derivatives

The clearing and settling of a security is fairly simple compared to derivatives, as it only encompasses the direct settlement of the security after the day of the trade. The settlement of derivatives is a more complex task due to the nature of derivatives. Until the termination of a derivative contract, the parties will eventually be involved in several payments or deliveries (Adam W. Glass, 2009) and will therefore be exposed to counterparty risk for a longer period of time. In conclusion a derivative implies a by far larger exposure to credit risk by reason of the (Glass, 2009) “combination of a much longer time horizon for completing transactions [, the] greater uncertainty as to the value (and even direction) of the ultimate transfer obligation [and] the unavoidable significance of counterparty credit risk in derivatives transactions”.

Appendix 3 gives a detailed process overview in the case of a „plain“ 10-years interest rate swap. The process steps within the blue frame include the valuation and the ongoring monitoring of both the underlying swap as well as the allocated collateral. The regular valuation of a OTC derivative poses often the problem of not having a liquid market for the derivative.

3.2.3.1. Bilateral clearing and the role of the International Swaps and Derivative Association (ISDA)

A bilateral OTC derivative contract involves participants which trade with one another. The undergone counterparty risk is mitigated by both sides with the help of collateralization and netting.

Collateralization is conducted by daily adjustments of guarantees on the basis of both the mark-to-market value of the contracts and the creditworthiness of the counterparty. Bilateral netting was “substantial: at end-2008, the gross market value of all OTC derivatives was $33.9 trillion. However, after one accounts for bilateral netting agreements, the gross credit exposure came to $5 trillion at end-2008.”

According to a survey undertaken by the ISDA (2009) “roughly two thirds of OTC derivatives exposures are collateralized and that the estimated amount of collateral in use at the end of 2008 was approximately $4 trillion, of which almost 85% was cash.” Following the quarterly report of the BIS (2009), one can calculate the “uncollateralized OTC derivative exposure” by deducting the above mentioned $4 trillion of collateral from the $5 trillion of gross credit exposure (Table 1), leading to circa $1 trillion.

ISDA

The ISDA offers a “Master Agreement” which is a bilateral framework contract between two potential counterparties. It contains general information and accords of a market participant as for instance basic corporate representations, basic covenants, events of default and termination. The framework does not include any specified description of a single deal. In order to define the derivative-specific information financial institutions using the “Master Agreement” are using “Confirmation” letters. These letters specify the transaction details the parties may enter into.

Netting

The Master Agreement and the sum of all confirmations, which define the transaction specific duties (e.g. interest payments) of both counterparties, are by definition one single contract. This allows the bank to summarize the amounts owed to a counterparty, to net their positions and to set one single net amount payable by one party to the other. The latter is defined as “payment netting” according to ISDA sources (www.isda.org).

The “Close-out netting” describes how to proceed in the case of a default of the counterparty. According to ISDA sources the application of the “Close-out netting” offers the possibility to “offset credit exposures between the two parties which will be combined into a single net payment from one party to the other”. Further on the “Master Agreement” puts claims originating from the default of a counterparty on a level with senior debt (this sensitizes credit derivatives to debt recovery rates, which are computed internally or obtained externally).

These two netting procedures are applied in the analyzed bank and mitigate effectively the credit risk of counterparties on a firm-wide level.

Margining

Depending on the so called “margin thresholds”, collateral in form of high-quality or securities or cash are requested. For the majority of derivatives the “margin threshold” is defined as the mark-to-market (value) of the previous day. However, due to the lack of a clearing house and due to uniqueness and therefore illiquidity of various OTC derivatives, the effectiveness of margining can be negatively influenced. This operational effectiveness is influenced by:

The collateral itself, meaning that e.g. a junk-bond may not.

3.3.1. The work of the clearing houses

A clearing house takes on an intermediary role for the execution of a contract between two counterparties. A clearing house is mainly responsible for the clearing and settling of trades within equities and derivatives markets.

For Glass (2009) the clearing process contains “post-trade operations including trade matching, confirmation and risk management. In trade matching and confirmation, the parties match and reconcile the terms of the trade as shown on each individual party’s records. Risk management includes the posting of maintenance or variation margin to secure transaction performance.” The settlement involves on the one hand the process of (cashless) payment transaction (e.g. definition of terms of payments) from the buyer to the seller and on the other hand the delivery vice versa, in order to (Adam W. Glass, 2009) “discharge its [the parties] obligations under the trade”. However, definition varies from market to market and from product to product.

3.2.3.2. CCP clearing

As stated above the counterparty risk (see section XXXXXXXXX) assumed by both parties when entering an OTC derivative contract is inter alia dependent on the time of the contract – more precisely the time between execution and settlement.

However, this additional risk factor can be mitigated – actually eliminated — with the help of the central counterparty element (CCP). The application of the latter is beneficial to both counterparties because they can pass on the counterparty risk – created by the originally bilateral contract between the parties — to the third-party “CCP” immediately.

The process of assuming the counterparty risk by the CCP for either party is called novation. Due to this process (Gross, 2006) “the CCP becomes the buyer to every seller and the seller to every buyer”. In the event of a defaulting counterparty, the CCP isolates the obligations of a counterparty and concentrates the counterparty risk of all party’s contracts on itself.

Therefore it needs to be funded properly to absorb a default and maybe to withstand further default due to contagion effects.

According to Gross (2006), CCP normally uses three “reinforcing mechanisms … including

access restrictions,

risk-management tools (such as collateralization), and

loss mutualization”

in order to cope with counterparty risk. The CCP only grants access to market participants, which they assume to have both a relatively stable creditworthiness and an operational infrastructure to bear their duties (e.g. margin calls). Similar to the future exchanges (e.g. SOFFEX, CBOT, etc.) collateralization consist on the one hand of initial margins (future potential loss of all open positions of a counterparty once defaulted) and on the other hand of margin calls, which are based on the daily mark-to-market fluctuations of the derivative and can even extended to intra-day margin when markets are volatil. Loss Mutualization dictates the claim on available collateral of the CCP in order to cover a loss from counterparty’s default. The mutualization goes beyond the laying claims to only the defaulter’s collateral, but includes the loss-sharing agreements with its other counterparties.

By definition a CCP is not subject to market risk, which can be defined as a change in value of an asset due to an adverse change of market factors. As a result of the novation process, the CCP holds as many short positions as long positions of the same underlying and therefore offsets its exposure theoretically to zero (except for the case of a default of one counterparty). The market risk remains with the counterparties.

However, most OTC derivatives and the respective risk management (incl. Collateralization) are cleared and settled bilaterally.

3.2.4. Implications to the sphere of action of Clearing Houses with regards to the events of the financial crisis

The question to be asked is: How effective are clearing houses in terms of reducing counterparty risk? Do maybe governments promise market participants “heaven and earth” concerning the effectiveness of clearing houses, whereas practitioners have to cope with the implementing of the latter.

The following chapter 4 will bring to light the points made by government representatives — alternatively representatives of regulatory bodies. They will be contrasted with the perspective of some academics.

In chapter 5 the results of two case studies undertaken will be analyzed.

The future of Clearing Houses

4.1. The Regulatory point of view

Positive

“Wider use of central counterparties (CCPs) for over-the-counter derivatives has the potential to improve market resilience by lowering counterparty risk and increasing transparency. However, CCPs alone are not sufficient to ensure the resilience and efficiency of derivatives markets. “

BIS Quarterly Review, September 2009

The BIS Quarterly Review, (09/2009), highlights the preference on the part of the BIS for an extensive implementation for CCP. Besides the advantages from an academic point of view, which will be described in chapter 4.2. an additional benefit attributed to regulatory bodies can be reached by CCPs: the increase in transparency by publishing of transactions (both by prices and quantities).

An IMF Working Paper (Segoivano and Singh, 2009) on Counterparty Risk in the OTC derivatives market assumes an ‘attractive’ bid/ask spread of “anywhere from 1-25 basis on notional value traded” (about $600 tillion – see Appendix 1) leading traders to “protecting their franchise, and therefore limit transparency and standardization.”. This lack of transparency leads to a market form which doesn’t have the characteristic of strong efficiency. In addition this leads to a price discrimination based on the behaviour of market makers. In order to overcome these weaknesses a CCP could be used to implement a market environment which is characterized by: great liquidity, high-level of transparency and a permanent accessibility.

The BIS report on counterparty risk (2009) points out the benefit from multilateral netting, allowing the CCP first of all to net amongst their counterparties, which leads to a multilateral net position. The latter number represents the outstanding net position between the CCP and the market participant. According to this report data “indicate[s] that multilateral netting of new CDS trades reduces gross notional exposures by approximately 90 percent. As more counterparties start using the CCPs, the benefits could be even larger.

On the basis of the BIS report (2009) a higher level of transparency would especially bring light to the obscure levels of exposures within the CDS market: “information should help [to] ensure that adequate collateral is posted by CDS protection sellers.” The BIS suggests further to raise the level of margins for short positions in CDSs in order to make it more expensive to enter these deals. This, in the eyes of the regulator, would help to mitigate the negative effect of “short-selling” a market participant and therefore to worsen its ability to raise money on the market and to increase its own “payoff” by increasing the likelihood of counterparty‘s default.

Negative

However the relationship has its downsides. For a regulator it is essential to oversight the systemic risk (see Appendix 7.5. for definition) of the financial system. By taking on enormous counterparty risk on itself the CCP turns out to be the single source of systemic risk; therefore the regulatory bodies have to attract enormous notice to the stability and the risk management procedures of the CCP. Furthermore Evanoff, Russo and Steigerwald (2006) pointed out that authorities will have to focus on the “potential for extreme events (with systemic implications). These are low probability, but exceptionally high impact, events in the tails in the probability distribution.” Whereas the interest of the market participants focuses on their own “management of day-to-day risks”.

4.2. The academic point of view

Positiv

Gross (2006) points out the practical advantages of a Clearing House. He describes basically two major benefits for participants of a CCP: First of all the “credit is homogenized” and second of all “credit risk monitoring is delegated”. Following Gross (2006) there is no need for any market participant to assess the counterparty’s creditworthiness s; hence the only counterparty existing in any contract is the CCP (however CCP’s creditworthiness needs to be checked). This ‘outsourcing’ of counterparty’s credit risk assessment reduces informational costs for the participants.

The credit risk is homogenized because each and every member follows general accepted rules concerning the collateralization and has to supply collateral according to his own gradual default risk. As described in chapter. the assumption of all existing counterparty risk of the trades on the CCP, calls for a broad funding of the CCP. Bringing forward the homogenization argument, Evanoff, Russo and Steigerwald (2006) state that a central counterparty makes market participants “completely indifferent to the identity of other market participants, a fact that lead to anonymous trading. This decreases transaction costs and contributes to an increase in market liquidity.”

Further on all participating counterparties have a genuinely interest to act in concert, because they are (Gauss, 2006) “collectively liable for losses, up to a predetermined level, and more importantly perhaps because they have a collective interest in the survival of the CCP, they have a strong incentive to work with and through the CCP to resolve issues. Since the CCP is the only direct counterparty of a clearing member, it effectively acts on behalf of the other, non-defaulting clearing members in pursuing legal remedies against any clearing member that defaults.”

A market participant involved in a bilateral agreed contract, which faces a default of one of his counterparties, is left alone when suing for the outstanding claim.

Jackson and Manning (2005) undertook the, from their point of view, the first quantitative analysis of benefits analyzing a change from bilateral to multilateral clearing arrangements, depending on the number of market participants. They found out, that the move tends to result in a decrease of costs and risk (under certain model-based conditions).

Negativ

Derived from the positive effect of not being obliged to assess the creditworthiness of every “business partner”, market participants clearing with a CCP need by all means to carefully assess the creditworthiness of the only remaining counterparty, the CCP itself. This can be done with the help of a rating. CCPs are rated by the major rating agencies.

Mutualization and loss-sharing agreements lead to a well-known problem of moral hazard (see Appendix 7.6. for a definition). When parties’ traders increase their risky positions, they leave the CCP (and their collective) behind with increased potential risk.

The product standardization when applying CCPs is sometimes critized by academics due to their limits when it comes to innovations. On the contrary a “bilateral agreement world”, serve as a medium for creation of new financial products. Of the same tenor, it is criticized on restricting the implementation of custom-made products – consequentially from the need for standardization.

4.3. The CCP’s point of view

Only Positive

Naturally, operators of CCPs give a favourable opinion about the effectiveness of CCP for the market and especially about the further implementation for other asset types. However there has to be distinguished between producing a valid argument and an argument only produced to finally generate more revenue for the operator. Since a CCP is neither a regulator nor a governmental organization the profit motive can’t be dismissed out of hand. On account of this the author wants to point out only some ‘qualified’ quotes.

CCP operators promote the advantages of using a CCP: increased efficiency and the lower level of cost and risk, (e.g. Euroclear, 2010). Participating in a CCP is a “collective investment of the market in risk management”, stated John Trundle from Euroclear in 2006. In fact as described above, using a CCP offers the opportunity to outsource (counterparty) risk management. Euroclear, by his own account the “world’s largest provider of domestic and cross-border settlement. for derivative transactions.”, absorbed during the Lehman Brothers turmoil twice the volumes as normal. Thanks to a stringent collateralization policy only allowing a “not-collateralized” ratio of 1% and a only intra-day credit allowance, Euroclear could assure to eliminate the counterparty risk of Lehman Brothers for all its participating members. Further on Euroclear takes advantage of its superior rating of AA+ in attracting market participants seeking for a “safe haven“.

CME Group and ICE

4.4 Summary

Regulators on a worldwide scale are discussing a broader use of CCP.

A CCP could help to centralize market data and to improve the transparency of data – even on a daily basis. Reporting to market participants would help regulatory bodies to more efficiently supervise the various OTC markets. This would as well be helpful for practitioners and academics.

Analysis

5.1. Explanation of the approach used and its limitation

I chose to use a “semi-phenomenological study”, in order to understand better the various viewpoints and their origination. The research I undertook includes therefore qualitative research in the form of face-to-face-interviews with open questions to some extent.

However, face-to-face interviews as modus operandi have its limitations. First of all banking confidentiality has to be named. Though the interviewee was informed about the compliance with the confidentiality of information used in the report, the banks strict adherence to banking secrecy restricts the interviewee to declare sensitive data, models. procedures or even opinions. Therefore this report can be characterized as a more qualitative approach giving inside information of the challenges banks are facing with respect to the implementation of CCPs to manage their OTC derivative business.

5.2. Case Study A

5.2.1. Description of the bank

Business Segments of the analyzed bank

The Group is a global financial services provider active in retail and commercial banking, credit cards, investment banking, wealth management and investment management services. Its geographical core area is Europe however it conducts business as well in Asia, the Americas, and Africa.

The conducted interview dealt solely with the bank s international investment banking activities.

Investment Banking Activities of the Bank

As a fully-fledged investment bank it is engaged in all products and services within the common markets: Commodities, Credit. Foreign Exchange, Equities, etc.

Activities in OTC Derivatives

As already mentioned the bank offers full service of all standard products and services according to standard business practice. Referring to the banks offer of OTC Derivatives the interviewee indicated that the bank is mainly active in:

Credit Default Swap

Single name instruments

Multi name instruments

Interest Rate Agreements

Commodity based Agreements

Equity based Agreements

Foreign Exchange Agreements

Ad 2) to 5): Each of them including Options, Forward, and Swaps

According to the interviewee the majority of OTC contracts are entered using “Master Agreements” and “Confirmation” issued by the ISDA.

5.3. Case Study B

Books

Resti, A. & Sironi, A. (2009), Risk Management and shareholders’ value in banking, John Wiley & Sons Ltd

Bessis, J. (2005), Risk Management in Banking, John Wiley & Sons Ltd

Hull, John (2007), Risk Management and Financial Institutions, Prentice Hall inc.

Jorion, P. (2007), Value at Risk, McGraw-Hill Companies

Articles

Theobald, M. (2009), « The credit crisis and risk management », Analyse Financière, No.30. p. 9-11

Author unknown (2010), “Base camp Basel” (2010), The Economist, January 23rd 2010, p. 60-63

Decoster, S. & Barroin, L. (2008), « Rapport Ricol: trente recommandations face à la crise financière », Revue Banque, p. 85-86

Measures, D. (2009), « Credit risk management and mitigation », Journal of Securities Operations & Custody, Vol. 2, Nr.2, p. 134-140

Elespe, D. (2009), « The Credit Rating Agencies (CRA) and the financial crisis », Analyse Financière, 3rd October 2009, p. 51-53

www.handelsblatt.com/unternehmen/banken-versicherungen/am-tag-als-raumstation-orion-abstuerzte;850318, 24.01.2005

www.bloomberg.com/apps/news?pid=20601086&sid=asUlN7J0cBLw&refer=latin_america

Adam W. Glass (2009) “The regulatory drive towards central counterparty clearing of OTC credit derivatives and the necessary limits on this”

Cecchetti, Gyntelberg, Hollanders (2009), “Central counterparties for over-the-counter derivatives”, Q4 2009, BIS Quarterly Review

Homepages

www.isda.org

www.ifsl.org.uk

https://www.euroclear.com

agriculture.house.gov/list/press/agriculture_dem/pr_071009_joint_OTC.html